How credit card issuers pay rewards without going broke
This is a guest article by Lance, the founder of the blog Money Life and More. Earning rewards from credit card companies like cash back and sign-up bonuses, astute credit card users may be wondering how issuers afford to pay these bonuses for people who don’t pay interest or late fees. Lance takes a look at this feat.
Credit card companies have been offering some pretty awesome rewards and sign-up bonuses recently. I personally have made almost $1,000 in credit card rewards last year, much of which came from sign-up bonuses. On top of that, I received cash back rewards from all of the credit cards I use on a regular basis.
Just so you can get an idea of some of the rewards I get…
With my Chase Freedom® card, I earn 5% cash back on up to $1,500 in combined purchases in bonus categories each quarter I activate. The categories usually change every quarter. In addition, there is unlimited 1% cash back on all other purchases.
I also have a Chase Sapphire Preferred Card that gives me 2% cash back on travel and dining and 1% cash back on everything else. It came with a 40,000 point sign up bonus after spending $3,000 in the first three months after opening my account. My last cash back card offers 1% on all purchases up to a spending limit of $10,000 a year and then pays out 1.5% cash back on everything else.
The credit card companies pay out a ton of money in rewards every year, but how do they pay for it? It helps to look at the problem of these reward programs from the credit card companies’ perspective before jumping right into how the credit card companies pay for it all.
The biggest potential problem about credit card rewards programs is that freeloaders take advantage of the offers.
Freeloaders
I am freeloader and I want you to be a freeloader too! If you aren’t a freeloader you absolutely should not be using these credit cards as they normally come with higher interest rates than a credit card without rewards. So what exactly is a freeloader?
A freeloader is someone who takes advantage of these credit card reward programs. They receive the awesome sign up bonuses and cash back offers that accompany the programs without providing any revenue for the credit card companies. Freeloaders always pay their balances off in full every month and never pay a dime (or even a penny) of interest. They never pay a late fee. They know their credit card rewards and fee schedules inside and out. They make sure they follow all the rules to never pay the credit card companies anything more than the purchase price of all of their transactions.
Some cards even have annual fees that are waived the first year. Most of these freeloaders will either get the fee waived in subsequent years or cancel their card. Some freeloaders won’t do this because the value of the rewards exceeds the annual fee, but I’d say the vast majority cancel or get the fee waived. They are freeloaders after all.
So if freeloaders exist, how do the credit card companies pay for the rewards?
Everyone else
If you have credit cards and you aren’t a freeloader then you’re paying the credit card companies (and the freeloaders) in one form or another. You could pay the annual fee, a late fee, a balance transfer fee, an over-limit fee, interest or any of the other fees and charges that credit card companies rely on for revenue. It doesn’t matter how the credit card companies get your money. The simple fact is they do get money from their customers and lots of it!
You must first meet many conditions in your credit card agreement in order to receive the rewards. Normally your account cannot be delinquent and you have to hit a certain points or cash back threshold before you can redeem your rewards. If you never meet those conditions you may never get paid those elusive rewards.
Consider these mind-blowing statistics:
- The average APR on a credit card with a balance on it was 12.81% in November 2012 (http://www.federalreserve.gov/releases/g19/Current/)
- Total outstanding revolving debt was $850.8 billion. (http://www.federalreserve.gov/releases/g19/Current/)
- 56% of consumers have carried a balance within the last 12 months. (http://www.statisticbrain.com/credit-card-debt-statistics/)
- Only 40% of cardholders have credit card balances of less than $1,000. (http://www.statisticbrain.com/credit-card-debt-statistics/)
The interest that credit card companies collect could probably pay for all of the rewards multiple times over before you factor in any of the fees or other revenue sources.
Other major expenses of credit card companies
There are other expenses that credit card companies must deal with that possibly cause a much larger impact to their profits than paying rewards. Delinquent accounts are big headaches for credit card companies. If the companies never collect on a delinquent account they lose both the principal and interest owed to them for that account. The other option is to sell the account to a collections company for as low as pennies on the dollar.
Credit card fraud and identity theft are more big headaches for the credit card companies. I was a victim of credit card fraud myself. I thought I was lucky, and that the fraudster had only gotten away with a $19.95 order of Proactiv acne cream. Unfortunately I was wrong, and the issue expanded beyond just credit card fraud, and I was a victim of identity theft. The thief initiated a balance transfer for over $3,000, and if I hadn’t caught it as fast as I did the credit card company would likely have lost every penny of it.
One last thought
Credit card companies offer these stellar rewards programs for a reason. That reason is to bring in more customers and make more money! If they didn’t work, credit card companies wouldn’t offer them. How do I know that?
Credit card companies are businesses. They still make a ton of money after paying out the credit card rewards, covering delinquencies and writing off the charges made from cases of fraud and identity theft. Don’t feel bad for taking advantage of these rewards offers. If you can get the rewards and bonuses without paying the credit card companies a dime you’re doing great in my book.
Editor’s note. To expand on the above, credit card companies aren’t losing money by offering rewards, even when you consider just the freeloaders. Offering rewards encourages customers to spend more, and with every swipe of the card, the financial industry profits from interchange fees. The bottom line is that the money spent on marketing expenses, including sign-up bonuses and rewards expenses, are more than worthwhile. I can’t imagine a typical consumer is worried about how the credit card companies are able to generate profits when paying out $100 to $300 per rewards customer per year; this is a tiny expense for an industry with oversized profits.
Photo: Flickr
Article comments
It’s been estimated that rewards account for about 45% of interchange cost. Since the merchants accepting your card pay the interchange, the merchant is paying for the rewards you receive.
However, if the merchant raises their prices to offset the cost of processing credit cards, you (and all consumers) are paying for the rewards you receive (in a round-about way).
My question is if they cut out rewards, would they lower interchange costs? Some would say yes but I think it’d be hard for them to give up that revenue.
I believe you have cause and effect reversed here.
Because the interchange charges are far higher than they need to run the business the competitive market has used those fees to offer rewards as an incentive to lure customers. The rewards did not beget the interchange fees, the interchange fees beget the rewards.
It’s an example of perfect competition working very well. And the reason it works is because their is tons of competition. The rewards are offered by the institutions that offer you the card. There are literally 1000s, probably 10s or 100s of thousands of card offers trying to get you to take their card. The reason why is because the cards are very profitable. Both in interest and in interchange fees. Since the interchange fees are drastically higher than what they need to run their business, a few places began offer incentives to get you to come to their card and they could use the interchange fees to pay for deadbeats. Eventually most places offered some kind of reward because that was what the competitive market was doing and everyone could afford it due to the interchange fees.
I always offer the parallel example of places that used to give away free steaks with a windshield replacement. I don’t know if that happened everywhere but it did here in MN. The glass companies always said, don’t worry, it won’t cost you a dime, its free and the insurance company will pay for 100% of your windshield, no cost to you and we throw in a free box of steaks as a thank you to you. MN had a law requiring full glass coverage at the time so everyone was eligible for this.
Except it’s not free. Clearly if these companies were not offering free steaks they could afford to charge the insurance companies less money for the cost of the windshield replacement. The attorney general sued the glass companies and shut down this practice as an obvious overcharging of the insurance companies to fund an unrelated activity. Simply calling the steaks free didn’t change the reality. They were not free and insurance companies were buying their customers steaks. Which in turn was raising everyone’s premiums so in effect everyone was buying their own steaks, whether they wanted to or not.
Rewards on credit cards are exactly like this. The interchange fee is high enough to support the rewards. Every merchant has to pay the interchange fee so the merchant is paying for your rewards. Except the merchant has to make a profit so they have to raise their prices to cover the interchange fee so we are all buying our own rewards whether we want to or not.
You are correct that they could still offer rewards without the interchange fee and make it up somewhere else but it would get a lot harder. The deadbeat card holders would truly become money losers to them now. Plus if they make the card have a high annual fee or higher interest rates then people who are going to carry high balances could determine that the cheaper interest rate with no rewards was a better deal. Not all would make that connection but some would. The proposition would be far less straight forward for the issuing card company to make sure the rewards were worth it.
My suspicion is that most of the rewards would eventually go away without the interchange fee.
It’s worth noting that while competition has worked perfectly for the card issuing companies it works horribly for the card processing companies. There are really only about 4 processor brands that are used in the majority of transactions: visa, mastercard, amex, discover. Discover doesn’t have too much of the market and visa and mastercard have most of it. They set the interchange fees and most of it goes to the card offering companies. They do this to make it lucrative for companies to offer cards (even though companies are giving most of the interchange fee away in rewards so it doesn’t serve the purpose it was originally designed for). If there was strong competition in the card processing business I am convinced this interchange fee of 2% would be squeezed down to under 1/2% in a matter of years.
It is simply exorbitant and it is basically all just being thrown back at the card holders as bribes anyway. Competition has basically removed the excess of it but since the competition was at the wrong point it removed it via a rebate process rather than just getting rid of it in the first place, which makes the whole process a rat races to try to get your own money back via rewards when a better solution is to just squeeze out the excess which will eventually result in lower prices at the retail sale point and you won’t need to try to get your money back because you will keep it in the first place.
Honestly i would rather keep the 1-3% than chasing expiring rewards. What can we do to change this practice? I would like to boycott it somehow, but if I pay cash, I will not change anything, just loose 1-3%. As a merchant I will start offering 3% discount on cash purchases. Any ideas?
All of the points from this article are valid as to how the CC companies make money in general but it’s not how they fund the reward programs for the most part.
As Jim pointed out, the primary thing that funds rewards are interchange fees. It’s not a coincidence that most rewards are around 1% with a few items that get higher rewards but in general its hard to average a whole lot over 1-1.5%. That is fully covered by the interchange fees. Yes, they could also be funding it a little bit out of interest rates but if the interchange fees went from 2% down to about .5% like they are in many other places the rewards would likely be far less valuable if not just disappear.
I think you have a point with the exchange fees, but if they had to lower exchange fees but instead increased revenue from another source they could still easily offer the rewards. A dollar is a dollar to the credit card companies, as long as they make more incremental revenue for each incremental expense they’ll continue to offer these programs I think.
Like Luke said, the interchange fees generally pay the rewards cash back/points. Merchants are charged typically 1-3% simply for the processing of the purchase and that generally covers the rewards. That doesn’t cover the sign up promotional deals like the free 25,000 points you might get for signing up with a card, but thats just a marketing cost for the companies to buy new customers. Ultimately the banks make money on average for every customer they drag in. While many of us pay the bills off every month and stay freeloaders there are other customers who may have great credit scores and may pay off the bills monthly but then end up unemployed and stuck paying 25% interest. Or people who overindulge in credit use and pile up a balance and pay 25% interest. The cash cow is the 25% interest.
I definitely agree that interest is the major cash cow. I have a feeling there are many smaller cash cows as well with all of the fees many of these cards come with.
I know that I use my rewards card more often than I would, especially when there is a special reward in a certain category. This boosts their swipe fees. I actually worked in the customer call-in center for a bank that had a big credit card operation. We(the c.c. division) were the cash cow for the entire company. They can well afford the rewards.
I think I’d always use a credit card, regardless of whether or not they offer rewards. For some, it may increase their credit card use and indeed increase the swipe fee revenue.
“We(the c.c. division) were the cash cow for the entire company.” This is also why stores all seem to have their branded credit cards. Branded credit card = higher per ticket average, increased loyalty, and more frequent shopper. Plus what you may spend on it outside the store.
I’m surprised credit card companies still allow/off such incentive programs to freeloaders like you and I. After all, I’m sure they can very easily figure out if you’re somebody they can make money from or not (based on credit score) and simply only offer such rewards to “qualifying” individuals which, of course, wouldn’t be a freeloader.
While we may be freeloaders today we might run into hard times tomorrow and need to carry a balance. I think that is what the credit card companies bet on.